The Trouble That Johnny Allison Sees

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Johnny Allison, chairman and chief executive officer at Home Bancshares in Conway, Arkansas, prides himself on running a very conservative institution with a strong credit culture. And Allison has not liked some of the behavior he has witnessed in other bankers, who are slashing their loan rates and loosening terms and conditions to win business in a highly competitive commercial loan market.

Allison says those chickens will come home to roost when the market eventually turns, and many of those underpriced and poorly structured loans go bad.

“Now is a dangerous time to be in banking, in my opinion. It is a scary time because our people want to match what somebody else did,” said Allison during an extensive interview with Bank Director Editor in Chief Jack Milligan for a profile in the 1st quarter issue of Bank Director magazine. (You can read the story, “Will Opportunity Strike Again for Johnny Allison?” by clicking here.)

Allison feels strongly enough about the credit quality at $15 billion asset Home that he’s willing to sacrifice loan growth, even if it hurts his stock price. In the following excerpt, Allison — whose blunt and colorful talk has become his trademark — opens up about the challenge of maintaining underwriting discipline in a highly competitive market.

The Q&A has been edited for brevity, clarity and flow.

BD: You said some very powerful things in your third quarter earnings call. And you said it in sort of the Johnny Allison way, which makes it fun and entertaining. But you were fairly blunt about the fact that you see stupid people doing stupid things. That has to have an impact on your performance in 2019. You’re letting certain kinds of loans run off because you don’t like the terms and conditions and the pricing. That impacts your growth, which then impacts your stock price. That has to be a difficult choice to make.
JA: It’s extremely tough, because my people in the field are seeing dumb stuff being done. “Well, so and so did this, or so and so did that, and, Johnny, they gave him three-and-a-half fixed for 10 [years], and interest only, and nonrecourse.” I mean, there will be a day of reckoning on those kinds of bad decisions, in my opinion. Am I going to write at three and a quarter [percent] fixed for 10 to 15 years? I’m not going to do that. Do I not think I’ll have a better opportunity coming next year to where I haven’t spent that money, and I spend it next year? So, my attitude is [to] take what they give us. Stay close to your customers, support your customers. It is extremely tough. It is one tough job keeping the company disciplined. Don’t let it get off the tracks. We’re known as a company that runs a good net interest margin. We’re known as a company that has good asset quality, that runs a good ship.

BD: If you were more aggressive on loan growth, if you were willing to play the same game that other banks were playing and not worry about the future so much, would your stock price be higher today?
JA: We don’t believe that. If I loan you $100 and I charge you 6%, or I loan you $100 and I charge you 3%, you’ve got to do twice as many loans just to keep up with me. And there’s a limit to how much you can loan, right? We got $11 billion worth of loans. We’re about 97% loan-to-deposit [ratio]. Could we go up to 100%? Sure. We were at [100%] over six years ago. The examiners fuss at you a little bit. But we’ve got lots of capital. So, we kind of run in those areas close to 100% loan to deposit. But we’ve got $2.7 billion worth of capital, so we can rely on that. Plus, the company makes a lot of money.

BD: You said in the earnings call that you were building up the bank’s capital because you didn’t quite know where the world was going, or you weren’t quite certain about the future. So, how do you see the future?
JA: I’m very positive with the future, except the fact I keep hearing these naysayers on and on. We’re optimistic people. I’m rocking with the profitability of this company, and [people] tell me the world’s coming to an end. Then the [bank’s] examiner came in during [the] third quarter and said, “The world’s coming to an end, Johnny. Get ready. Be prepared. Get your reserves [up].” We didn’t ever see it. It didn’t happen. Could somebody be right? Could there be a hiccup coming? Let me say this, and I said it on the call, banks are in the best financial condition that they’ve ever been in.

Someone said, “Boy, you give the regulators credit for that.” I said, “Regulators had nothing to do with it. Absolutely nothing to do with it.” What did it was [the financial crisis in] ’08, ’09, and those people who wanted to survive, and those people who wanted to keep their companies and don’t want to cycle through that again. What’s happening is, the shadow banking system is coming into the [market], and they’re taking our loans. How many [loan] funds are out there? They all think they’re lenders. Every one of them think they’re lenders. And they’re coming into the bank space. Where we’re at 57% loan to value, they’re going to 95% loan to value.

There’s the next blow up, and that’ll hurt us. We’re going to get splashed with it. We’re not going to get all the paint, but we’re going to get splashed with that.

That’s the next problem coming, these shadow bankers, the people chasing yield. REITs. Oh, God. REITs. I’m in at $150,000 a key in Key West, Florida, with a guest house owner who is a fabulous operator. We financed her for years and years, and she’s built this great program with these guest houses. She sold it to an REIT for $500,000 a key. Now, let me tell you something, you can’t have an airplane late getting into Key West. There can never be a wreck on [U.S. Highway 1]. And there can never be another hurricane. Everything has to be hitting on all cylinders and be perfect to make that work. That’s kind of scary to me. We’ve seen several of these REITs coming [in with] so much money. They won’t give any money back to the investors. They won’t say, “We failed.” Instead, they’ll go invest that money. And they’re just stretching that damn rubber band as far as they can stretch it, and I think some of those rubber bands are going to pop.

[Editor’s note: An REIT, or real estate investment trust, owns and often operates income-generating real estate.]

So, I think that’s the danger. I don’t think it’s the normal course of business. I think those things are the danger. And when it slows down a little bit like it did, these bankers panic. They just panic. “What can we do to keep your business? What can we do?” They just lay down and play dead. “What can I do? What can I do? Two and a half? Okay, okay, okay. We’ll do [loans at] two and a half [percent].” We just got back from a conference, and they’re talking in the twos. Bankers are talking in the twos. I don’t even know what a three looks like, and I sure don’t know what a two looks like. So, I can’t imagine that kind of stupidity.

BD: So, where are we in the credit cycle?
JA: Well, two schools of thought. One, that we’re in a ten-year cycle, and it’s time for a downturn.

BD: Just because it’s time.
JA: Just because it’s time. Johnny’s thought is that we were in an eight-year cycle with [President Barack] Obama, and he didn’t do one thing to help business. Absolutely zero things to help any kind of business at all. Didn’t know what he was doing. Nice guy. Be a great guy to drink beer with. Had no clue. And then here comes [President Donald] Trump. So, did the cycle die with Obama and start with Trump? That’s my theory. My theory is that [the Obama] cycle died, and we’re in the Trump cycle. Now, if we have a downturn, if something happens somewhere, he’s going to do everything he can to get reelected, right? So, he’s going to try to keep this economy rolling. But if we have a downturn, it’s not going to be anything like ’08, ’09.

The regulators blame construction for the [financial crisis]. It wasn’t construction that caused the crash. It was the lenders and the developers that caused the crash, because nobody put any money in a deal. Nobody had any equity in a deal. I remember many times, my CEO, I’d say, “See if you can get us 10%.” No. [The customer] got it done for 100% financing. If you want the deal, they give it to you. But it’s 100% financing. There wasn’t any money in the deal. There was no money in those deals, and when the music stopped, they just pitched the keys to the bankers, and here went the liquidation process. I was involved in it, too. I did some of it myself. So, I’m not the brilliant banker that skated that. I was involved in it. Not proud of that, but I learned from that lesson. I learned from that lesson.

Now is a dangerous time to be in banking, in my opinion. It is a scary time, because our people want to match what somebody else did. That’s my toughest job. And a lot of them think I’m an ass because I hold so tight to that. Now, let me tell you. This is my largest asset. This is my baby in lots of respects. I have lots of my employees that are vested in this company. I have lots of shareholders, local Arkansas shareholders that are vested. We have created more millionaires in Arkansas than J.B. Hunt [Transport Services], or Walmart, or Tyson Foods. Individual millionaires, because they believed in us and invested with us, and I am very proud of that.

How Risk Management Is Changing

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One inescapable truth about the post financial crisis: far more sophisticated, future-focused risk management is required going forward. New capital—and good business sense—demand it.

human-camera.jpgWhat does this have to do with credit culture, often associated with the practice of making sound loans? A great deal, at least as banking evolves beyond the financial crisis. To accomplish this requires a changed mindset, and credit culture is largely a mindset. Despite its traditionally esoteric nature, credit culture must not only be felt but enumerated. No longer should the former Supreme Court Justice Potter Stewart’s famous line about knowing obscenity when you see it be operative in defining your bank’s credit culture. To define credit culture, this leads us to the spectrum of qualitative versus quantitative, concepts known to every lender and credit officer. We believe it’s time to take this dichotomy beyond classic credit analysis, which most of us think of when hearing those terms, and project it onto the broader spectrum of optimal, future bank-wide portfolio risk management.   

Qualitative analysis implies subjective judgment—and in the greater scheme of things can also encompass the transactional, tedious loan-by-loan assessment of risk. We know transactional risk sensitivity is particularly important in relationship to the size of the bank. If one big loan goes down, that can have a huge impact on a small bank, for example. On the other end of the spectrum, which we can label quantitative, we have aggregated portfolio risk assessment, often combined with financial models used to predict outcomes. Many believe excessive dependence on modeling lead to the financial crisis in the first place.

Therefore, one could argue that on one end of the spectrum of optimal credit risk management, we have transactional risk (individual loan analyses and servicing) and on the other end, aggregated risk (modeling and forecasting). Worshiping exclusively on either end of the spectrum is problematic. Understanding only individual loan risks is like losing sight of the forest for the trees. And at the other end, we all know models are only as good as the integrity of what informs them (i.e., the transaction-based discreet data points, tediously mined from underwriting). There’s a sweet spot somewhere between the two polar opposites. But in the end, there must be a bottom line, a sum of all the parts to accurately project a bank’s risk profile, both present and future. Each stakeholder needs that profile depicted in summary fashion.              

How does one accomplish this blending of the theoretical qualitative and quantitative disciplines? Ideally, a bank should begin with an underwriting process that ensures adherence to its policies and guidelines—while cataloguing exceptions. Concurrently, it needs to have a complementary process that aggregates the individual loan data, and performs multiple portfolio-wide tasks, including stress testing, and calculating the allowance for loan and lease losses (ALLL), risk grade migration and potential credit losses (beyond the reserves), etc. Products have been developed to perform these tasks, on both ends of the spectrum, and frankly at costs far less than what some of the national providers of analytic tools are quoting.   

Lastly, much of credit culture jargon is historically, or backward- focused. That leads to statements such as “We grew this much in loans,” or “We had this percentage of past dues,” or “Our yield improved to this.” Regulators and investors read the call report. They are focused more on the future, as bank boards and management should be.  Boards need to ask questions such as, “Where are we trending in the various quality, growth, and profitability measures?” or “Where’s the next bubble in the portfolio?” or “Where will our non-performing loans likely be in one year?”

Success in banking going forward will be defined largely by institutions’ shifting from this traditionally historic to a forward-looking focus—and not just within a strategic planning or budgeting context—but embedded in the credit culture itself.  Simply put bank management and boards will have to be as conversant in PD (probabilities of default) and EL (expected losses) as traditional acronyms such as DSC (debt service coverage) and LTV (loan-to-value) ratios. With the widely anticipated high level of bank mergers and acquisition activity in the next few years, an additional premium will be placed on being informed and credible with these more macro and predictive concepts. They don’t replace the old reliable transactional measures; they just partner with them to quantify the risk going forward. The investors, the regulators—and common sense bank management—will mandate this.